Investors and advisors have plenty of questions about where themarkets are heading under President Donald Trump's leadership.

Ben Inker, head of asset allocation for money manager Grantham,Mayo, Van Otterloo & Co., dissects the economic scenarios thatcould guide the markets and its participants over the next fouryears in his latest quarterly report.

Like his bearish partner Jeremy Grantham — who debates ifworkers will get the economic benefits of their votes in hisquarterly letter — Inker seems pessimistic: “The newadministration's plan for a large fiscal stimulus seems poorlydesigned, oddly timed and very unlikely to produce the sustainedstrong growth that Trump claims he will provide.”

But Inker outlines the varied economic shifts that could makesuch growth possible, along with explaining what factors may leadto dire economic straits during the Trump years.

“Even in the unlikely possibility that we do achieve the growthTrump is calling for, it is not obvious that it would be the boonto the stock market that investors seem to think,” the portfoliomanager explained.

“The fiscal stimulus does, however, seem likely to lead totighter monetary policy and has a reasonable chance of leading torising inflation. How the economy responds to these two potentialoutcomes will tell us a good deal about whether [a] Hell orPurgatory scenario is correct, which will be helpful to investorseven if the policies themselves prove not to be,” he wrote.

What's Next?

Driving markets upward in recent years have been low short-terminterest rates, he explains, asking: Will cash rates shift like the“old normal” of 1 to 2% above inflation, or they will stay aroundthe average of the last 15 years, about 0% after inflation?

If they average 0% real, we have a “Hell” scenario. A shift backto 1 to 2% above inflation is “Purgatory.”

In November, the U.S. 10-year Treasury Note was yielding about1.55%, suggesting the bond market was “very much in the Hellcamp.”

At year-end, the yield moved up to 2.45%, nearer toPurgatory.

As for whether or not GMO's leaders have changed their outlookon the likelihood of Hell, the short answer is they have not, Inkersays.

“If Hell is a permanent condition for markets, it should not bereadily changeable by the policy choices of a single U.S.administration, to say nothing of the fact that we do not yet knowwhat those policy choices will be for an administration that hasjust taken office,” he explained.

Limbo Land

Inker, however, says we are really in a state of uncertainty or“Limbo.”

As he sees it, the Trump administration has not removed thepossibility of Hell from GMO's investment forecasts, but it hasgiven the group “some hope that we may be able to figure outwhether we are in Purgatory or Hell within the next few years,”which would get us out of Limbo.

If those who believe we are in a period of secular stagnationare right and equilibrium interest rates have fallen far, we could“see rising interest rates slow the economy considerably, and theFederal Reserve will find itself unable to raise rates as much asit is planning to.”

The economy could then slide back into a recession, promptingrates to come fall, or we might “settle into such a precariouslow-growth mode that it will stop raising rates by the time we getto 2% or so on Fed Funds.”

This outcome, Inker says, “would be at least suggestive that weare in Hell.” Still, ending up in recession in the next few years“is not an ironclad guarantee we are in Hell.”

The current expansion is “getting pretty old,” he adds.

This could shift on the down side if Trump's protectionistrhetoric is put into action and leads to a global trade war,pushing the economy back into a recession.

If monetary policy “doesn't matter,” as some economists argue,the economy could move along through the Fed's gradual rate rises“without too much trouble,” according to Inker.

If the economy remains “reasonably strong,” the federal fundsrate is likely to rise at least to around 3% and even higher.

Portfolio Perspective

Higher rates, of course, will push up bond yields; higher bondyields will provide some competition for stocks; and the highercost of debt will likely discourage companies from taking on moredebt for stock buybacks.

Price-to-equity ratios may “come back down to levels consistentwith their longer history of somewhere in the middle to upperteens,” the GMO executive said. “Investment portfolios will take ahit, but we will at least be back to a level of valuations whereinvestors can expect to earn the kinds of returns they need in thelong run. It will be Purgatory, and while Purgatory is painful, itis finite.”

A Trump Success?

But what happens if the U.S. economy achieves sustained growthof 3.5 to 4%? A massive reacceleration of productivity, which couldsupport such growth, “seems unlikely,” according to Inker.

“Attempting to grow a 1.5 to 2% economy at 4% is a recipe forinflation,” he said. Rising inflation means “far faster interestrate increases than is generally being priced in, and we willlikely learn relatively quickly whether the economy can withstandthose increases,” Inker wrote.

In terms of equity investors, it seems nearly impossible thatthe right interest rates for 5% economic growth would be 0% in realterms. “So Hell, in that case, would seem to be off the table, andwith it a big part of the justification for higher P/Es for thestock market,” he stated.

Inker gets even more pessimistic: “Our best guess is actuallythat faster growth might well be associated with a stock markettrading at significantly lower valuations than today. The 1960s and1996 to 2005 periods may have been the halcyon days of productivityin the U.S., but it is the current period that has been best forprofitability.”

Wages are another important consideration, since it can beargued that sustained strong economic growth requires labor gettingmore of its share to boost consumption.

“This would almost certainly require corporate profits to fallas a percent of GDP. And if profit margins fall materially, even amoderate acceleration of revenue growth would lead to falling, notrising, overall profits,” Inker explained.

Tax cuts, he argues, have not theoretically or empirically beenimportant to profitability. When tax rates fell in the 1980s, theprofit spike came “a good 20 years later,” and historic analystsshow tax rate falls “have generally been associated with falling,not rising, profits,” Inker said.

Real Strategy

According to GMO, if Trump's policies work or demonstrate thatwe are not stuck in secular stagnation, this will be generally “badfor stocks and bonds and good for the economy.”

A return to a recession should be “good for bonds and notnecessarily terrible for stocks because valuations can stay high,buoyed by low cash and bond rates,” Inker said.

The portfolio manager explains that there is “a meaningful plusside to what Trump is doing” — we should “learn some useful thingsabout the economy and therefore where valuations will wind up inthe coming years.”

Neither Hell nor Purgatory are great places for investors, buteither one is “arguably better” than Limbo.

“We are still putting the higher probability on the Purgatoryoutcome, which implies that rising rates will not kill theeconomy,” he said, though GMO is also preparing for otheroutcomes.